Speech
Financial Conditions and the Australian Dollar – Recent Developments

Introduction

Thanks to XE for the opportunity to be here in Melbourne to speak to you. A lot has happened in
financial markets globally and in Australia since late last year. I thought it would be helpful
to summarise the key developments, including revisions to the global economic outlook, concerns
about downside risks and changes to market expectations for monetary policy paths. I'd also
like to discuss their implications for the Australian economy and the Australian dollar.

But first, a brief caveat is in order on the topic of exchange rates. It's often said by
Reserve Bank staff that we are not in the business of forecasting exchange rates. But, just as
importantly, we also need to be humble when explaining the past behaviour of exchange rates. In
that regard, it is worth recognising that models of exchange rates provide only rough estimates
of the more enduring relationships.

The International Backdrop

After a lengthy period of relative stability, global financial markets have been more volatile
over the past few months. The incoming data from around the end of 2018 was associated with a
tightening in financial conditions: global equity prices declined; corporate credit spreads
widened; issuance of corporate debt eased; and volatility picked up across most markets (Graph 1).
And in the space of only a couple of months, the market's expectations for monetary policies
changed markedly and there was a notable downward shift in yield curves.

Graph 1

What prompted these changes? In part, market participants reassessed their expectations for
global growth. This reflected a run of data that was a bit weaker than had earlier been
expected, particularly for the industrial sectors and trade. However, this was not true of all
of the incoming data. Indeed, labour markets have remained in good health; the US labour market
data of late have been especially strong. Moreover, labour market tightness is evident more
broadly and wages growth is picking up in a range of advanced economies.

Forecasts for growth of global economic activity have been revised lower, but only marginally. In
late January, the IMF's forecasts for global growth were trimmed for 2019 and 2020, by 0.2
and 0.1 percentage points, respectively (Graph 2). Growth of Australia's major trading
partners is expected to decline slightly in 2019 to around its historical average. It is also
worth noting that at least some of this moderation in growth has been by design. Over the past
year or more, policymakers in both China and the United States have sought to ensure that growth
in their economies was placed on a more sustainable footing.

Graph 2

But that's a story about what is most likely to happen (the central tendency of
the distribution of possible outcomes). Much of the market reaction of late has been prompted by
greater concern about the potential for adverse, but less likely outcomes – the
so called ‘downside risks’.

From Australia's standpoint, at the top of the list of risks is the outlook for our largest
trading partner, China. One concern relates to the extent and nature of leverage. The Chinese
authorities had earlier moved to contain the growth in leverage, particularly where it was
funded using so called ‘shadow financing’ channels. While proceeding broadly as
intended, this earlier tightening in financial conditions has contributed to the slowing in
Chinese economic activity. And yet leverage remains high and there is still much to do to ensure
the soundness of the Chinese financial system. So the tension between sustaining growth and
financial stability remains.[1]
While the authorities may want to help support growth of economic activity, they recognise that
a broad-based easing of policies runs the risk of undoing what has been achieved with the
deleveraging to date. Another concern for China is the adverse effects of trade tensions with
the United States. The dispute is weighing on Chinese economic activity and trade. Softer demand
from China has weighed on growth elsewhere in Asia, and the region would be relatively exposed
to a more marked slowing in China if that was to occur.

Consistent with the focus of global financial markets on downside risks, price adjustments have
been in the form of a rise in risk premia in equity and corporate bond markets. In US equity
markets, for instance, price declines in late 2018 were accompanied by only small downgrades to
analysts' expectations for earnings growth over the medium term. This implies that the
willingness of investors to pay for earnings declined materially (Graph 3). In other words,
the equity risk premium went up.[2]
Similarly, in corporate bond markets, future default rates expected by analysts hardly moved
over this period. And yet spreads widened sharply, reflecting an increase in credit risk premia.
While early 2019 has seen a partial retracement of these moves, both equity and credit risk
premia remain higher than a year ago.

Graph 3

This rise in equity and credit risk premia follows an extended period where they had been
unusually low, and even uncomfortably low, particularly in the United States. Some adjustment to
these was inevitable, and welcome from the perspective of financial stability. While these
premia remain a bit higher than a year ago, they are still not that high by historical
standards.

At the same time that markets became more concerned about downside risks to economic activity,
they became less concerned about upside risks to inflation. Part of that reflected the revisions
to the outlook for growth. But lower oil prices have had a significant effect on the near-term
outlook for inflation, and breakeven inflation expectations have shifted down accordingly.

The combination of all of these changes – reduced expectations for growth and inflation,
increased concerns about downside risks, and higher corporate risk premiums – has seen
market participants revise down their expectations for the paths of monetary policy rates.
Longer-term sovereign yields have also declined noticeably (Graph 4).

Graph 4

The change in expectations for monetary policy has been most pronounced in the United States
(Graph 5). As recently as December, market pricing implied an expectation that the US
Federal Reserve would increase interest rates in 2019. Indeed, this was supported by the
so-called ‘dots’, which show the median of individual Federal Open Market Committee
(FOMC) members' projections of the most likely outcome. Currently, market pricing implies no
increases in 2019 and even some chance of a reduction in the fed funds rate in 2020. Once again,
the repricing appears to reflect concern over what could happen, as much as what is
considered most likely to happen. One way to illustrate this is by examining the
survey-based expectations of primary dealers in the US money market. These data show that
primary dealers are increasingly concerned about the ‘tail risk’ that the fed funds
rate will return to zero in the next few years. Nevertheless, their most likely
forecast remains for further rate increases.[3]

Graph 5

Central bank policy expectations have shifted elsewhere as well, although generally by less than
in the United States (Graph 6). That difference is likely to have contributed to a
depreciation of the US dollar after its trend appreciation last year.

Graph 6

I will return to foreign exchange markets in just a moment, but let me briefly take stock. The
upshot of these recent developments is that global financial conditions have tightened a little.
The cost for corporations to raise capital through equity and debt markets has increased a bit
in the advanced economies. But overall conditions are not tight, with monetary policy rates
still low (relative to most estimates of neutral) and government bond yields also low. Indeed,
bond yields are generally lower than they have been for a couple of years.

Implications for Australia

Over recent months, developments in Australian financial markets have been similar in many
respects to those offshore. Equity prices fell, credit spreads rose, and so did various measures
of financial market volatility; although, some of the more pronounced moves seen late last year
have been retraced in early 2019. These changes have again largely been a story of risk premia
increasing from low levels and were associated with rising concerns about downside risks, both
internationally and domestically.

The outlook for the domestic economy has also shifted, and the Bank has revised down its
forecasts for both growth and inflation. Our forecasts continue to project a further gradual
reduction in spare capacity in the economy, with the unemployment rate trending lower. That
should see wages growth pick up, although only gradually, and inflation is also expected to
increase gradually. The Bank's Statement on Monetary Policy and the Governor's
recent speech provided comprehensive updates to this picture.[4]

In response to this shift in the international and domestic outlooks, market expectations for the
next move in the cash rate have switched signs: the markets have assessed that the next move is
more likely to be down than up. That has been reflected in lower bond yields, alongside the
effect of lower oil prices on market-implied inflation expectations. Two-year bond yields in
Australia have tended to decline by a bit more than in many other major markets (Graph 7).
Part of that change is somewhat mechanical given that in both Japan and the euro area policy
rates are close to their effective lower bounds. This latest change in Australia's interest
differential extends the trend decline that has been underway for five or more years.

Graph 7

Over the past couple of months, the Australian dollar has depreciated by about 4 per cent
on the basis of the trade-weighted index (TWI). This largely reflects the effect of the
appreciation of the yen and the renminbi, which collectively comprise nearly 40 per cent
of the TWI. The yen appreciation may have been driven by the tendency of Japanese investors to
bring some of their funds back home during ‘risk-off’ periods in global financial
markets.

Graph 8

The decline in Australian bond yields relative to other advanced economies is likely to have
contributed somewhat to the modest depreciation of the Australian dollar of late (Graph 8).
However, over much of the past 18 months or so, higher commodity prices appear to have worked to
limit the extent of Australian dollar depreciation.[5] Indeed, commodity prices
have increased noticeably of late. This largely reflects disruptions to supply, particularly of
iron ore. In short, there are a number of forces affecting the Australian dollar, but they have
been pulling in different directions. Accordingly, the Australian dollar remains within its
relatively narrow range of the past few years.

Having noted the low volatility of the exchange rate over recent years, I need to briefly touch
on the recent flash event in currency markets that no doubt caught the attention of many of you
in this room.[6] On 3
January, in the span of a few minutes, a sharp appreciation in the yen against the US dollar
quickly cascaded into the Australian dollar, which depreciated by up to 7 per cent
against the yen (Graph 9). At the same time, bid-ask spreads had widened significantly.
However, trading conditions quickly returned to normal and currencies largely retracted their
earlier moves.

Graph 9

It is difficult to draw firm conclusions on the causes of such events, but as we outlined in the
recent Statement on Monetary Policy, three factors are likely to have contributed.
First, there was the liquidation of ‘carry-trade’ positions, notably from highly
leveraged Japanese retail investor accounts. These appear to have been automatically triggered
following the initial appreciation of the yen. Second, these liquidations occurred at a time
when market liquidity was seasonally low, such that the foreign exchange market was more exposed
to imbalances between buy and sell orders. Recent flash events have tended to occur around this
same time of day, in between the close of US markets and the start of Asian trading. It was also
early in the new year and a public holiday in Japan. Third, as in previous flash events,
algorithmic trading strategies may have amplified the move, for example, by adding to demand to
buy the yen as it appreciated.

It is also difficult to be definitive about what restored orderly market functioning. Market
contacts suggest that discretionary buying of Australian dollars by traditional market-making
banks and institutional accounts helped to stabilise conditions and re-establish the process of
price discovery.

Ultimately, this event did not lead to wider disruption. But the growing list of such disorderly
moves in key financial markets in recent years clearly bears close watching.

Conclusion

There have been modest revisions to the outlook for economic activity and inflation globally.
Additionally, downside risks are attracting more attention, from both market participants and
central banks. These changes have been accompanied by a rise in the markets' assessment of
risks relating to the corporate sector – albeit from relatively low levels. There has also
been a reassessment of the outlook for monetary policies, and interest rates have shifted down
across the yield curve. The decline in sovereign yields has worked to partially offset the
effect of higher risk premiums and so finance is still readily available to borrowers at
relatively low rates. Broadly similar changes in economic and financial conditions have also
occurred domestically. And while commodity prices have risen of late, Australia's terms of
trade are still forecast to decline gradually over the next couple of years. Pulling all of this
together, it is not so surprising then that the Australian dollar has depreciated a little over
recent months. While the exchange rate is still within the relatively narrow range of the past
few years, the recent depreciation is helpful at the margin given that there remains spare
capacity in the economy and inflation remains below target.

Endnotes

I thank David Jacobs for excellent assistance in preparing these remarks.
[*]

It is also possible that investors viewed those forecasts as being too optimistic. While
higher bond yields can also see investors apply a larger discount to future earnings,
bond yields have declined in recent months.
[2]

The FOMC dots represent the median of FOMC members' expectations of the most likely
(modal) outcomes. In contrast, observed market prices reflect not the central scenario
but rather a probability-weighted average of all expected outcomes (that is, the entire
distribution). Because of this, tail risks can move market pricing, even if the most
likely outcome has not changed in the eyes of market participants.
[3]

See Lowe P (2019), ‘The Year
Ahead’, Address to the National Press Club of Australia, Sydney, 6 February.
[4]